:+:CHAPTER 9 Aggregate demand & Supply

posted on 15 Feb 2011 16:34 by marry-dodo


Aggregate demand & Supply

The Aggregate Demand Curve

The aggregate expenditure framework that we have been using focuses on the components of aggregate demand (C, I, G, and the foreign sector). Recall that when we are looking at the changes in aggregate output stemming from changes in AE, the price level was assumed to be constant. While the AE framework is useful for depicting the multiplier effects of changes in C, I, G, or the foreign sector, it has some limitations. First, as aggregate output changes, so does the price level. In addition, the AE model does not fully develop the supply side of the economy. In this lecture, we will develop a framework that incorporates both the supply side of the economy as well as changes in the price level. Let us get started!

How does the aggregate demand (AD) framework relate to the aggregate expenditure framework? Both have aggregate output (income, Y) on the horizontal axis, but while the AE model has planned aggregate expenditures on the vertical axis, the aggregate demand curve has the price level on the vertical axis. The AD model, then, relates changes in the price level with changes in aggregate output. Let us examine how price level changes generate changes in aggregate output.

Deriving the Aggregate Demand Curve


          We start our examination of the link between the price level and aggregate output with the money market. A change in the price level affects money demand. An increase in the price level will increase the demand for money and cause the money demand curve to shift to the right. This causes the interest rate to increase, which causes a reduction in planned investment. Aggregate output will decrease in response to the decline in investment by more than the initial decline in investment due to the multiplier effect. 

  This whole process works in reverse as well. A decrease in the price level will lower money demand and the interest rate. Planned investment will increase in response to the lower interest rate and cause aggregate output to increase by more than the increase in investment.

          What we have demonstrated, then, is an inverse relationship between the price level and aggregate output. This relationship is what is depicted by the aggregate demand curve. The AD curve plots varying price levels and their corresponding levels of aggregate demand. In other words, each price level and its corresponding level of aggregate output plots as a point on the AD curve, 


The Aggregate Demand Curve: A Warning

 An important point to note is that the aggregate demand curve is markedly different from a market demand curve for a particular good or service. On a market demand curve, only the price of the product and its quantity are allowed to vary. Everything else is held constant (income, the price of other goods, and so on). The aggregate demand curve is not even the sum of all individual market demand curves for an economy.

To see why the AD curve is different than a market demand curve, let us examine why market demand curves have a negative slope and contrast this with the reasons for the downward sloping AD curve. To make the picture a little more concrete, let us pick a particular good, say rye bread, to illustrate the properties of a market demand curve.

There are two main reasons why a market demand curve has a negative slope. The first is known as the substitution effect. If the price of rye bread increases, for example, it becomes more expensive than before relative to other goods. (Because all other prices are held constant, an increase in the price of rye bread makes it relatively more expensive than before the price rise. People will substitute rye bread, to some degree, with other types of bread, rolls, crackers, or other substitutes. Thus, an increase in the price of rye bread will lead to a reduction in quantity demanded.

The second reason market demand curves have a negative slope is known as the income effect. Recall that when drawing a market demand curve, income is held constant. With income held constant, an increase in a good’s price means that consumers will not be able to buy as much of it as before while maintaining their purchases of other products. Thus, an increase in the price of a good will reduce the quantity demanded of the good.

The AD curve, on the other hand, has a negative slope for different reasons. There cannot be any substitution or income effects here. There cannot be a substitution effect because we include all goods on the horizontal axis and all prices on the vertical axis. With all goods accounted for, all substitutions between goods are accounted for. Similarly, there cannot be an income effect because income (aggregate output) is not held constant in the case of the AD curve. It is allowed to change by virtue of the fact that aggregate output (income, Y) is on the horizontal axis.

So why does the AD curve have a negative slope? We described one reason earlier in this lecture. With an increase in the price level, money demand increases and interest rates rise, causing a decline in investment and aggregate output. The other reasons for the negative slope of the AD curve are examined next.




Other Reasons for a Downward-Sloping Aggregate Demand Curve

  Just as with planned investment, consumption spending by households is inversely related to the interest rate. With the increase in interest rates stemming from higher prices and increased money demand, consumption spending will fall. As with planned investment, a decline in consumption will cause aggregate output to decline. The response by investment and consumption spending to changes in interest rates stemming from changes in the price level is known as the interest rate effect.

Another reason for the negatively sloping AD curve is known as the real wealth effect or the real balance effect. Recall that when we derived the AD curve, monetary policy was held constant. With a given amount of money in the economy, an increase in prices means that fewer goods and services can be bought than before the price rise. With fewer products purchased, fewer products will be made. Thus, aggregate output will decrease with an increase in the price level.


Shifts of the Aggregate Demand Curve

The aggregate demand curve we saw above is based on the assumption that the government policy variables G, T and Ms are fixed. If any of these variables change, the aggregate demand curve will shift.

          Monetary policy will cause changes in aggregate demand. An increase in the money supply, for example, will increase aggregate demand and cause the AD curve to shift rightward. 

  Expansionary fiscal policy, consisting of an increase in government spending (or a decrease in taxes) will cause aggregate demand to increase and the AD curve to shift rightward. 


The Aggregate Supply Curve

Aggregate supply is the supply of all goods and services. There is considerable disagreement among economists about the meaning and shape of the aggregate supply curve. Many economists believe that the AS curve has different features in the short run than in the long run. We will first develop the concepts of the AS curve within the context of the short run, and then look at some of the implications of the long run on the AS curve.

The Aggregate Supply Curve: A Warning

The AS curve shows the relationship between the total supply of goods and services in the economy and the price level. Just as the AD curve is not the summation of the market demand curves for the economy, the AS curve is not the summation of the market supply curves in the economy.

Recall that in deriving market supply curves, the input prices are held constant. An increase in output price causes firms to respond to the resulting higher profit per unit by increasing production. For the AS curve, however, this phenomenon is not possible because the vertical axis shows the prices of all goods and services. There must, therefore, be other reasons for the positive slope of the AS curve.

Aggregate Supply in the Short Rule

One reason for the upward-sloping AS curve is that wages and input prices often lag output prices. While an increase in the price level on the AS diagram means that overall prices in the economy are going up, not all prices go up uniformly. There is evidence that wages and input prices lag output prices. For example, one reason that wages rise more slowly than output prices is that workers often have longer-term contracts during which wages are specified for some time into the future. If prices rise unexpectedly, the wage increases specified in these contracts will increase by less than the rise in output prices. 

          Note that at low levels of aggregate output (between points A and B) the AS curve is relatively flat, while at high levels of aggregate output (between points C and D) it is nearly vertical. What is the reason for this?

To answer this question, let us think about what the short run means in economics. In microeconomics, you may recall that the short run is defined by the presence of at least one fixed factor of production. For example, in the short run, firms can adjust output by changing the number of workers and quantity of inputs used. These firms, though, are constrained by the size of the existing factory. In the longer run, if the firm wants to increase production, it can increase the size of its factory. In the short run, however, the fixed size of a firm's factory acts as a capacity constraint. If the firm is producing at low levels of output and has excess capacity (extra factory space), it can increase output relatively easily. If, however, all of its factory space is being utilized, it is much more difficult (and costly) to increase output.

An analogous idea can be applied to the economy as a whole. The Federal Reserve issues estimates of the nation's capacity utilization rate. During recessions, when the economy is at low levels of aggregate output, there is excess capacity in the economy. For example, during the recession of the early 1990s, the capacity utilization rate was just under 80 percent. This means about 20 percent of the nation's factory space was not being utilized then. In addition, during low levels of aggregate output, the unemployment rate increases due to the presence of cyclical unemployment. With excess factory capacity and idle workers, the economy can more easily (and more cheaply) expand output than when the productive capacity is fully utilized. Thus, aggregate output will increase substantially with only a modest increase in the price level. This is what is shown by the relatively flat portion of the AS curve.

In contrast, at high levels of aggregate output when capacity utilization is high, there are much fewer idle resources. Factory space is nearly fully utilized and the unemployment rate is low. In this situation, it is more difficult (and costly) to gain further increases in output. Even sharp increases in the price level only bring about very small increases in aggregate output. This is what is shown by the steep portion of the AS curve.

There must be some time lag between changes in input prices and changes in output prices for the aggregate supply curve to slope upward (if there were no lag, it would be vertical). Wage rates may increase at exactly the same rate as the overall price level if the price-level increase is fully anticipated. But most employees do not receive automatic pay raises, and sometimes increases in the overall price level are unanticipated.


 Shifts of the Short-Run Aggregate Supply Curve

 Let us look quickly at some of the factors that can shift the AS curve. Then we will put aggregate supply together with aggregate demand to explain the price level in the economy. As we will see, shift in either aggregate demand or aggregate supply will cause inflationary or deflationary changes in the price level. The factors that can shift the AS curve are summarized in the figure below. We will briefly go into each factor.

  Changes in wages or input prices will cause the AS to shift. Increases in wages or input prices will cause a decrease in aggregate supply and a leftward shift of the AS curve. Declines in wages or input prices will cause aggregate demand to increase. For example, the dramatic decline of world oil prices during the first part of 1998 caused a rightward shift of the AS curves for many nations. The extent to which AS increased depends on the degree to which oil is used as an input in a nation's productive processes. In the United States, for example, oil is an important input for electrical generation and many manufacturing processes. An unexpected change in input costs that causes a shift in the AS curve is termed a cost shock or supply shock.

Shifts in the AS curve can also be caused by any factor that affects the productivity or productive capacity of the economy. Increases in the size of the labor force, factory space, stock of capital, or improvements in technology or productivity will shift the AS curve to the right.

On the other hand, decreases in productivity or productive capacity will cause leftward shifts in the AS curve. Decreases in research and development, lack of investment in physical capital, and decreased educational and training opportunities, can all lead to decreases in aggregate supply. Similarly, wars, natural disasters, and adverse weather will shift the AS curve to the left.

  As shown in the right panel of the figure above, changes in a nation's aggregate supply can also be the focus of deliberate public policy. The supply-side economic policies of the Reagan administration of the 1980s are an example of this. The promise of these policies was economic growth without inflation. To see how this might work, let us turn now to how aggregate supply and demand interact to determine the equilibrium price level